In its simplest form, short selling is selling shares that you don’t own. Just like the broker will loan you cash to buy more shares, the broker will also loan you shares that you can sell. When you [ts]sell short[tm]Borrowing shares from your broker to sell a stock that you don’t own with the hope of the price going down so that you can then buy the shares back at a lower price and return them to your broker.[te] and borrow shares, think of it as having a loan of shares (and not cash) that you must return at sometime in the future. This concept confuses a lot of new investors, but it really shouldn’t.
Most virtual trading accounts will allow you to short sell so you should definitely practice shorting with your virtual account before you try it in your real brokerage account. You might want to wait a while before you consider a short selling strategy. Sure, you can make money selling short, but you could also come up very short if the stock that you shorted skyrockets.
Here is how it works in detail:
Suppose you do some research and think that LUV’s traffic is falling and the price of oil is skyrocketing and you believe it will continue to do so for at least the short-term. You place an order to Sell Short 100 shares of LUV and you get filled at $10.
Your broker will borrow the shares for you and sell these shares and your cash balance will go up by $1,000 and your Market Value of your stocks will now go down by $1,000 (you now owe the broker 100 shares of LUV). If you’re correct – and the price of LUV starts to drop – you can then purchase that number of shares at a lower price and replace those that you “borrowed.” This is called “Covering Your Short” and you will pocket a decent profit on the short sale.
However, should you be wrong and the price of LUV increases, you may be less than pleased with this strategy as you will have to go out and buy the LUV shares at a higher price such as $12.00 and now you have lost the difference in the prices or $200.
[mark]A lot of people talk about how risky shorting is, but the reality is that the only difference between shorting and buying on margin is that if you short a stock it can go upwards to $1,000s of dollars, but when you buy a stock the most it can down is to $0.00. So, when you [ts]buy on margin[tm]Borrowing money from your broker to buy stock.[te] you know that the most you can lose is the value of the stocks you bought, but when you short stocks you could technically have unlimited losses if the stock goes to infinity![endmark]